A good education can be invaluable, but it seldom comes for free. In these days of rising housing costs, interest rates and taxes, it is getting harder and harder for some families to help younger family members get that education. In my last article, I devoted a few thousand words to the most common way of funding these pursuits – Registered Educational Savings Plans or “RESPs”. Today’s missive focuses on another way to help fund an education, even for families that have already maxed out RESPs: In-Trust for Accounts or “ITF Accounts.”
Despite their benefits, RESPs may not be a one-stop solution, particularly if Junior has Ivy League aspirations or educational pursuits that seem to span decades. For other families, the numerous rules surrounding RESPs and penalties that can arise if a child doesn’t go to school or use up all of their grants and gains, may cause them to look for a more flexible alternative.
That’s why families look at other educational funding strategies as either an alternative to or in addition to RESPs. ITF Account are one of those choices and, on first blush, there seems like there is a lot to like: less initial paperwork, no funding limits and more flexibility on the back end should junior wishes to busk rather than earn a baccalaureate. The tax savings while junior is a minor also offer appear to offer tantalizing tax savings – accounts funded through an inheritance, a gift from a foreign relative or by the Canada Child Tax Benefit allow all income and gains to be taxed on the child’s return, although ITF Accounts funded from other sources usually tax income (but not capital gains) in the hands of the contributor while the child is a minor.
Unfortunately, despite the surface appeal, there are some significant drawbacks to ITF Accounts and some practical complications that might get in the way of some of the theoretical tax savings. Read on and decide for yourself whether ITF Accounts are an ingenious solution or a problem just waiting to happen. Before I begin, a quick shoutout to Canadian Moneysaver Magazine reader Claire Scribner for her invaluable questions and comments!
From a legal and tax perspective, ITF Accounts are informal trusts, which means that they operate according to the same basic principles of those elaborately detailed written trusts that I’ll talk about in my next article, but without all the structure, details, costs and paperwork that goes along with their more glamorous cousins. That means that there is someone managing the assets (“the trustee”), on behalf of the person who is entitled to the benefits of the account (the “beneficiary”). Thus, many parents are the trustees of ITFs for which their children are beneficiaries. Theoretically, ITFs should be taxed inside the trust and all income or realized gains not distributed or deemed to be distributed taxed at the highest margin rate for the trustee’s province.
Is It Really AN ITF Account?
As is so often true, however, life is more complicated than it may appear at first glance. First, it may be debated whether you’ve actually created a trust at all by the CRA since certain legal formalities are required and ITF Accounts rely on solely the account opening documents rather than the lengthy trust documents that go with a formal trust. It could be that you’ve merely opened a non-registered account earmarked for the child that should be taxed in your name or you’re acting as agent for the child and their babysitting funds rather than as a trustee. If all of this sounds confusing, then you’re not alone. If you want to establish a true ITF account, you’d want to confirm the intention to gift, the items to be gifted and identity of the person entitled to benefit from the largesse. The account opening documents should hopefully clarify the trustee and the beneficiary. Ultimately, this can be a lot to expect from ticking some boxes and filling in a few blanks.
Moreover, the CRA would also look at who has been paying the tax on ITF Accounts. Since ITFs generally don’t apply for a trust number (which is like a SIN number for trusts) and minors cannot establish their own investment accounts, ITFs are typically opened using the trustee’s SIN number. As a result, all tax slips for the ITF will also be issued in the trustee’s name. That means that if the trustee doesn’t report the income and gains on their own tax return, the CRA automatically picks up on that and starts sending out nasty reassessment notices. Although an accountant friend of mine advises that it may be possible to then go back and forth with the CRA about this every year, the hassle factor and potential accounting costs if someone else is doing this may not be worth it, particularly if the ITF is not a large account and / or the income would have otherwise been taxed in the adult’s hands anyway (such as if a parent funded the ITF). As a result, despite the best of intentions, if the trustee has been paying tax on the income and gains, that might be enough for CRA to deny that a true ITF had been created.
In some cases, in fact, this denial may be a blessing in disguise. If the account is treated like a trust and none of the income or gains have been paid out of the trust or promissory notes for these amounts payable to the child issued, the CRA can argue that the income and gains should be taxed in as trust, which means at the highest marginal rate inr the trustee’s province of residence. In other words, the ITF account might become a tax albatross rather than a tax saver.
For those willing to go the extra mile and fight this battle, such as when many years of tax savings still lie ahead and you think you’ll be able to tax even income in the child’s hands, I suggest that the trustee treats the ITF like a formal trust, which requires the following:
- All taxable income or gains should either be taken out of the account and spent on the youngster, or the trustee writes formal promissory notes on behalf of the ITF to the beneficiary for these amounts that are immediately cashable, although mom and dad are still entitled to blithely ignore junior’s demands for the cash until (s)he come of age. This hopefully prevents the CRA from taxing the income in the trust at that province’s highest marginal tax rate.
- Document your intentions to create a trust through a separate document when opening the ITF Account and be consistent in stipulating who pays the tax on the income and gains each year.
- Investigate getting a formal trust number from the CRA and using that number for the ITF’s bank or investment accounts rather than the trustee’s personal SIN number. Expect a lot of questions from those financial institutions and hassle regarding where the money has come from and request for details.
- Assuming you survive the administrative quagmire of actually opening accounts in the ITF’s name, be prepared to file annual trust tax returns on behalf of the ITF. The rules and disclosure requirements for trusts are in the process of changing significantly. At this point, the proposed legislation suggests that ITF Accounts worth less than $50,000 owning things like GICs and publicly traded securities may not always have to file tax and information returns, depending on their activity that year, but this may change.
- If hoping to get all income taxed in junior’s name under one of the previously listed exceptions to the general rule, don’t commingle (a word I try to fit into daily conversation) money qualifying for an exception with money that does not or risk having income taxed in the trustee’s hands.
- Keep records, records and more records. This means tracking the source of the ITF funds, particularly claiming an exception to the general tax treatment of income, as well of the expenses mom and dad paid on junior’s behalf that the trust is reimbursing.
Some other Potential Benefits of ITF Accounts
Although having capital gains and, perhaps, income taxed in the youngster’s hands can be a wonderful thing, particularly it’s still many years before (s)he’s old enough to buy their first drink, ITF Accounts may provide some other benefits in the right circumstances, including:
- Protecting assets for the child if the parents get divorced or, perhaps, against creditors, since the money in the ITF no longer belongs to the person funding the account. If it doesn’t legally belong to the trustee and (s)he didn’t fund the account 10 minutes before filing for bankruptcy, ITF Accounts should ultimately live to fund another day.
- Avoiding Will challenges, taxation, probate fees and unexpected results at the trustee’s death. Although ITF Accounts can have other problems if a trustee dies within money still in a child’s ITF Account, it should still belong to the child beneficiary, regardless of the deceased’s Will. If the money was just kept in a separate non-registered account in the dead trustee’s name, it would be distributed according to the deceased’s Will. Accordingly, unless the trustee’s Will specifically says that the non-registered account passes to the child, it would be distributed as part of the residue of the estate where it might pass into unintended hands, could be scooped up by estate creditors or tied up in Will challenge litigation.
Why ITF Accounts Keep Lawyers up at Night
Even if you thrill at the thought of the extra paperwork and never turn down the chance to bicker with the CRA, there are many other reasons why you may wish to give an ITF Account a hard pass. Here are some of those scary contingencies:
- Loss of flexibility and control. Once the money is gifted, the money belongs to the child. That means that before your child is old enough to drink in the US, they have the absolute right to demand their money and spend it as they wish. Accordingly, if you’re worried if your child has a thing for fast cars and trips to Maui, an ITF Account might be a ticking timebomb. On a related note, the money cannot be used for anyone but the child, no matter what life surprises await. A non-registered account without the tax advantages of an ITF Account allows the parents or grandparents to retain control of the money if the child goes off the deep end or it turns out later that the money would ultimately be better spent on themselves or another family member.
- Estate complications on the child’s death. If the child dies with money in the ITF Account, it becomes part of that child’s estate. Since most children can’t or don’t have valid Wills, that means that the money will be distributed according to the laws of intestacy in that province. In addition to potentially paying probate fees and expensive court applications in order for someone to manage that estate for the dearly, the money may end up in the wrong hands. For example, how would you feel about your ex-spouse getting 50% of the ITF Account you funded by working overtime and forgoing vacations if your child died without dependants or a spouse?
- Complications on the trustee’s death. Unless the trustee’s own Will stipulates who manages the ITF account, the task will generally fall to his or her own executor. This person may not be right person for the job, particularly in blended family situations when your new wife ends up managing the account a stepkid.
- Potential liability for inappropriate investment decisions. Admittedly, this is a stretch, particularly for smaller accounts. All the same, I strongly recommend against a penny-stock heavy strategy, as trust law says that all investment decisions should be reasonable ones depending on the timeline and intention for the account.
The Bottom Line
While ITF Accounts can play a valuable role in educational funding in the right circumstances, I don’t see them as the best alternative in many others. I am far more comfortable with them in the following circumstances:
- The child is already close to university age and has already demonstrated that they have their act together.
- The person funding the account is okay with the child using the money for other purposes should the child not go to university or have money left over afterwards.
- The funder has ample other resources should life through them a curveball.
- The account size isn’t so small that it’s not worth the hassle or complications and not so large that it would be a catastrophe if things went wrong. For larger amounts, a formal trust is a far safer option that cover off what happens if things don’t work out and provides the trustee with far more control, including not requiring a full payout at age 19 or allowing distributions to other beneficiaries in some circumstances, such as a single educational trust for a group of children or grandchildren rather than pinning all of your hopes on a single child / grandchild.
- The trustee is a details person.
- Income and capital gains will both be taxed in the child’s hands (or the account is set up to minimize taxable income until the child is an adult) and would otherwise be taxed in the gifter or trustee’s hands at a much higher rate so that there will be enough tax savings to make the risk and hassle worthwhile.